Dividend yield vs the 4% rule

[Brit71]

Long before I found this community, or mindset, I was following a lot of the ideas - particularly in regards to investing.

So I had consolidated all my pension funds and put them in a low cost stockbroker platform and bought the Vanguard FTSE 100 tracker. (This is all UK based in case you're wondering about some of the products or terms).

One concept I wasn't aware of was the 4% rule, so I was thinking this would be to build a capital sum and then I'd get some income bearing investments. At some point I had an epiphany and realised that those income bearing assets would also be shares. So why not buy income bearing shares (I couldn't find a transparent and low cost fund) and put them on reinvestment?

I then reacquainted myself with the UK based investment philosophy of HYP - the "High Yield Portfolio" - a diversified portfolio of high capitalisation high yield UK (later modified by me to include US) shares with a solid dividend paying history.

This build up has mostly been incremental so I still have a core FTSE fund (about 35%) and also a fairly well diversified portfolio of income bearing shares (almost all the rest).

In May the FTSE yield was around 3.5% and the shares yielded about 5%. A 30% difference and switching my remaining tracker fund to shares of a similar yield would move me considerably closer to covering our current spending with investment income.

Now I've learned about the 4% rule which should free me from only living off income and also simply switch off the investment picking, but I'm still albeit very slowly researching new shares to buy.

Can people please explain why I'm "wrong" here?

I'd like to understand this attachment to low cost trackers AFTER the capital accumulation phase. If I can simply sell my portfolio, buy a fund (or three) and set it to dividend reinvestment and regular top up then that would be a mild time and worry saver. But 30% is quite the difference.

(If there's a similar discussion feel free to point me to it or merge the thread)

[nereo]

You may wish to read through the [now lengthy] “stop worrying about the 4% rule” sticky.  There has been in-depth discussion about why there is no ‘magic’ to dividend investing / High-Yield portfolios. It also dives into why one should not worry about selling shares vs ‘living off the dividend.’

Most of the people recommending a dividend strategy are using survivorship bias (only considering the stocks which have increased their dividend in the past) to ‘prove’ their strategy works, and/or they have an incomplete understanding about how stocks and dividends work, and/or they ignore taxes, and/or they don’t really understand the 4% “rule” and the background behind it.

All of which doesn’t mean your current strategy is “wrong” - only that it isn’t likely to be an improvement, and may very well slightly underperform over a variety of market conditions.

[BeanCounter]

Well here in the US, divideds are less tax efficient than capital gains.

[bacchi]

There's a long list of solid, dividend increasing, stocks that slashed their dividends during the GFC.

A good example is Bank of America (BAC on the NYSE). It not only slashed its dividend but the stock price fell from $50 to $6 in 3 months at the end of 2008. Neither the dividend nor the share price have recovered.

Sep 03, 2008   0.64 Dividend
Dec 03, 2008   0.32 Dividend
Mar 04, 2009   0.01 Dividend
[...] more penny dividends
Sep 03, 2014   0.05 Dividend


The point being that you have to pick the correct stocks that will continue paying out during a recession. As a total market indexer, I just had to wait until 2011 to be even.


Edit: An article I found with a quick search. Note that AT&T (NYSE: T), spotlighted in the article, cut their dividend just this year. https://www.latimes.com/archives/blogs/money-company/story/2009-03-06/money-gone-dividends-lost-in-2009-already-top-2008-cuts

In the banking sector, Wells was the last of the Mohicans: With [Wells Fargo's] cut, not a single financial company remains in the S&P 500 list of the top 25 dividend payers, in terms of total dollars paid out annually.

The #2 payer in the S&P at the time, Exxon, is still paying a decent dividend. Are you willing to hold an oil producer/refiner long term in the era of the EV?

[Financial.Velociraptor]

European shares traditionally yield more than US ones of otherwise equivalent earning power.  Tax law is part of it.  But part of it is Americans have somehow come to value 'innovation' as "better" than 'income'.  The higher yielding shares in London and Frankfurt among large caps tend to be mature, slow growth, cash flow gushing businesses.  They often have medium to wide "moats" and can be expected to trail the broad market over long periods of time but with much lower volatility. 

The same is true of the higher yielding sectors among securities listed in NY and Chicago.  You give up growth if you focus on income.  For some reason, a lot of people want to be purists and hyper focus on growth or income instead of having some of both.  It becomes especially nonsensical when people don't consider the need to adjust their bond allocation to reflect the inverse of their Sharpe ratio. 

Put another way, Efficient Market Hypothesis suggests that if the market prices a stock for a "high" yield, it is signaling expectations its growth will be lower than comparable peers with a lower current yield. 

Not enough has been written, IMO, about using a more growth oriented portfolio in early accumulation phase and tilting more towards income oriented investing as retirement date approaches.  People on "here" will froth at the mouth over Dr. Pfau's 'bond tent' but act like you can't achieve some of the same thing with asset classes other than bonds. 

This next part is US centric and you might consider these as part of your US allocation.  There are three types of stocks in the US that receive tax advantages in exchange for a regulatory requirement to pay out most of their funds from operations as distribution.  These are Real Estate Investment Trusts (REIT) [many flavors but all real estate industry], Business Development Companies (BDC) [a sort of 'second' banking sector, specializing in loans (sometimes secured by equity) that are too large for the regional banks but too small for the Investment banks to underwrite bonds for], and Master Limited Partnerships (MLP) [resource sectors, like midstream oil and gas, timber, productive farmland, mining projects, etc.]  All of these traditionally trail the broad market return of the S&P but with much higher current yields.  Note that MLPs do not pay a '1099' distribution for tax purposes, you will be issued as US IRS "K-1" (and it is a freaking HASSLE, that has prompted to me exit all MLP holdings).

 

[Telecaster]

Long before I found this community, or mindset, I was following a lot of the ideas - particularly in regards to investing.

So I had consolidated all my pension funds and put them in a low cost stockbroker platform and bought the Vanguard FTSE 100 tracker. (This is all UK based in case you're wondering about some of the products or terms).

One concept I wasn't aware of was the 4% rule, so I was thinking this would be to build a capital sum and then I'd get some income bearing investments. At some point I had an epiphany and realised that those income bearing assets would also be shares. So why not buy income bearing shares (I couldn't find a transparent and low cost fund) and put them on reinvestment?

I then reacquainted myself with the UK based investment philosophy of HYP - the "High Yield Portfolio" - a diversified portfolio of high capitalisation high yield UK (later modified by me to include US) shares with a solid dividend paying history.

This build up has mostly been incremental so I still have a core FTSE fund (about 35%) and also a fairly well diversified portfolio of income bearing shares (almost all the rest).

In May the FTSE yield was around 3.5% and the shares yielded about 5%. A 30% difference and switching my remaining tracker fund to shares of a similar yield would move me considerably closer to covering our current spending with investment income.

Now I've learned about the 4% rule which should free me from only living off income and also simply switch off the investment picking, but I'm still albeit very slowly researching new shares to buy.

Can people please explain why I'm "wrong" here?

I'd like to understand this attachment to low cost trackers AFTER the capital accumulation phase. If I can simply sell my portfolio, buy a fund (or three) and set it to dividend reinvestment and regular top up then that would be a mild time and worry saver. But 30% is quite the difference.

(If there's a similar discussion feel free to point me to it or merge the thread)

My comments are related to the US stock market/tax laws.   But I assume there are some similarities.   In a nutshell, most of the return of the US stock market is from price appreciation, and over time less and less has been from dividends.   A number of reasons for that, taxes being one.   The problem with dividend investment strategies is that they are hard to well.    Good companies, like say Microsoft and Apple usually have low dividend yields.   The converse is usually true too:  Crappy companies have good dividend yields.    So it is a tough job to find good companies with good dividends.  Income ETFs typically don't perform any better that index ETFs and some do worse. 
I do pick some individual stocks, but I focus on good companies, period and don't look at the dividend. 

That said, I personally don't think dividend strategies are necessary either.   As I mentioned most of the return is from price appreciation.   So by focusing on dividends, you are perhaps focusing on the least important part.    Some people like the certainty of a quarterly check, but checks from selling appreciated stock cash just as easily.   

[Brit71]

Thank you everyone for the time on this.

I will have a (closer) look at the sticky post on the 4% rule.

I'll also try to look more closely at the US tax situation as this seems to be the root of most, although not all, of the aversion to dividend investing on this forum. It may also help me decide where to look for further US stocks and look for any warning signs in the UK

I think I'm starting to see why the accumulation method works in the US, and so on this forum, but at least on the face of it doesn't make so much sense in a non US context.

Or am I missing a non tax driver for the accumulation strategy?

[wageslave23]

Thank you everyone for the time on this.

I will have a (closer) look at the sticky post on the 4% rule.

I'll also try to look more closely at the US tax situation as this seems to be the root of most, although not all, of the aversion to dividend investing on this forum. It may also help me decide where to look for further US stocks and look for any warning signs in the UK

I think I'm starting to see why the accumulation method works in the US, and so on this forum, but at least on the face of it doesn't make so much sense in a non US context.

Or am I missing a non tax driver for the accumulation strategy?

It actually has very little to do with taxes. Being able to delay taxes on capital gains is just a nice added benefit. It's all about seeking the most diversification (owning all stocks regardless of dividend payments) and the highest returns (generally lower dividends and higher capital gains).  It doesn't matter whether a stocks returns are from dividends or capital appreciation.  With stock buy backs, and splits, and dividend reinvestment it all comes out the same mostly.  The only thing to focus on is total return. Conceptually, what is the best thing a growing company can do with their excess money? Give it back to the investors in the form of a dividend? Or reinvest it to make even more money?  If they have a really good use for the money and can get a higher return, then I want the company to keep the excess money and get me more money.  That's why I gave them my money in the first place.

[Telecaster]

The non-tax driver is what I said up above.   It is really hard to create a dividend strategy that outperforms simply holding the index.

[nereo]

@Brit71 - one 'higher-level' thing to be aware of is that from an efficient market standpoint, any dividend that a company pays out (in theory) reduces the share price of the stock by an equivalent amount. For the purposes of stock pricing, a dividend is an ongoing expense, a liability. If a company stopped paying out a dividend its share price *should* rise... once investors stopped freaking out that the cessation of the dividend wasn't some harbinger of doom.

There's no magic to dividends.  In theory it's just one way of returning profits to shareholders.

[Rob_bob]

@Brit71 - one 'higher-level' thing to be aware of is that from an efficient market standpoint, any dividend that a company pays out (in theory) reduces the share price of the stock by an equivalent amount. For the purposes of stock pricing, a dividend is an ongoing expense, a liability. If a company stopped paying out a dividend its share price *should* rise... once investors stopped freaking out that the cessation of the dividend wasn't some harbinger of doom.

There's no magic to dividends.  In theory it's just one way of returning profits to shareholders.

What I would like to know is the interest payed on a corporate bond considered an ongoing expense?  I don't believe bond interest payments reduce the stock price, why not?

What is the difference between paying a dividend, bond interest, payroll, employee health insurance premiums and building rent? 

[Financial.Velociraptor]

@Brit71 - one 'higher-level' thing to be aware of is that from an efficient market standpoint, any dividend that a company pays out (in theory) reduces the share price of the stock by an equivalent amount. For the purposes of stock pricing, a dividend is an ongoing expense, a liability. If a company stopped paying out a dividend its share price *should* rise... once investors stopped freaking out that the cessation of the dividend wasn't some harbinger of doom.

There's no magic to dividends.  In theory it's just one way of returning profits to shareholders.

What I would like to know is the interest payed on a corporate bond considered an ongoing expense?  I don't believe bond interest payments reduce the stock price, why not?

What is the difference between paying a dividend, bond interest, payroll, employee health insurance premiums and building rent?

@Rob_bob

There is a concept in academic finance called "total shareholder return".  Therein, you should calculate yield as the total cash spent on distributions, share buybacks, AND debt repayment, (as a percentage of market cap) as a percentage yield.  It is perfectly valid, at least academically, to consider debt expansion/contraction in your 'yield'.

[vand]

"Natural Yield" is not a foolproof strategy, or even a strategy that will guarantee a >4% SWR even if your shares yields higher than 4%. Why?

- Dividends are not gauranteed. They are paid out at the discretion of companies' managment.
- High divdend payers are usually indicative of mature company that are past the high growth stage
- Dividends are just one form of shareholder return. The others are: buyback, debt repayment, acquisition & reinvesting in R&D.  Over time all these other alternatives can raise the value of a company more than simply paying it out as dividend, and dividend payouts are very much an opportunity cost for any company that chooses to pay them
- In many countries (but not the UK) dividends are very tax inefficient
- Dividend paying companies are not immunue to the natural business cycle. The time that you need dividends to be sustained the most may well be the time when companies are cutting them.
- Dividend growth of your portfolio may not match inflation. Even if your portfolio naturally yields >4% over time the increases in dividends may not keep up with inflation, meaning that at some point you are faced with selling down capital


All that said, I do (still) think that a high dividend strategy - combined with proven value investing fundamentals - can be a goods strategy. One of the cardinal sins of active investing is to overpay for growth, and adopting a high dividend/value approach will most certainly ensure that you sidestep that particular landmine.

[clifp]

What I would like to know is the interest payed on a corporate bond considered an ongoing expense?  I don't believe bond interest payments reduce the stock price, why not?

What is the difference between paying a dividend, bond interest, payroll, employee health insurance premiums and building rent?

That is an excellent question.
The short answer is that bond interest, payroll etc. are expenses that a deducted before tax. They directly impact a corporation's net profit. These expense are reflected in the stock price, via the P/E ratio. Dividends are paid after taxes, so in some case you can have a corporation paying dividends even though it didn't make a profit. Obviously this situation can not exist for long.

[clifp]

In May the FTSE yield was around 3.5% and the shares yielded about 5%. A 30% difference and switching my remaining tracker fund to shares of a similar yield would move me considerably closer to covering our current spending with investment income.

Now I've learned about the 4% rule which should free me from only living off income and also simply switch off the investment picking, but I'm still albeit very slowly researching new shares to buy.

Can people please explain why I'm "wrong" here?

I'd like to understand this attachment to low cost trackers AFTER the capital accumulation phase. If I can simply sell my portfolio, buy a fund (or three) and set it to dividend reinvestment and regular top up then that would be a mild time and worry saver. But 30% is quite the difference.

(If there's a similar discussion feel free to point me to it or merge the thread)

Besides the 4% thread, there are several other threads about dividends that are worth checking out. (search for dividend)
My caveat, is I think it is possible maybe even probable, that dividend investing makes more sense for  European/UK retirees than Americans. So I would also do some searches for European-focused academic dividend studies

When I retired in 2000, dividend investment looked attractive for both practical and financial reasons.  Having dividend and interest income that exceed your expenses eliminates the whole issue of when to sell stock/bonds to fund your retirement.  At the time there was a number (but by no means all) of studies that showed that a portfolio of dividend stocks provided similar returns to the total market, but with lower risk. Since high dividend stocks generally have a lower Beta (a measure of volatility) than stocks with no or minimal dividends.

It served me well until the great recession 2008-9. The great recession saw more dividend cuts than even the great depression so that was the first bullet in the strategy. The death blow was the fantastic returns of growth stocks since 2009, specifically the FAANG stocks and other tech companies. They pay no or minimal dividends, so if you were holding dividend stocks you missed out on the huge returns of Google, Amazon, Tesla etc. Whatever performance advantage dividend stocks may have had in the past the performance advantage of growth stocks dwarfed it.

It is not clear to me that value stocks will catch the performance of growth stocks in my lifetime. Facebook, Apple, Microsoft, have fundamentally changed the economy, in a way that I don't see  J&J, Berkshire Hathaway or General Mills or Motors ever doing.  I think this same phenomenon also explains why US stocks have dramatically outperformed European stocks over the last 15 years.

So intuitively it seems to me that European value stocks with a higher dividend yield may be a good place to invest your money.  Especially, since I think the odds of the next FAANG stock coming from a European startup founded in the last few years seem really remote.

[ChpBstrd]

Aside from REITs, MLPs, and BDCs, if an American company pays a high dividend it is because management has no better use for the capital. It means management has taken a look at the situation, evaluated lots of possible investment ideas from expansion, to marketing, to R&D, to efficiency improvements, to vertical integration, to mergers... and found that none of these possibilities will earn their shareholders an acceptable rate of risk-adjusted return. They are out of options, at a dead-end, and outflanked by competitors all around.

Those realities and management's fiduciary responsibility to shareholders lead to a decision to slowly liquidate the firm over time The plan is to drain funds from the company while it is still profitable and return the cash to shareholders. The hope is that the inevitable decline can be managed, and that the loss of equity value in the future will be offset by the value of a string of cash dividends right now. This is a better alternative than investing the company's cash into projects that lose money, and it keeps the shareholders from deserting the firm completely.

So when you buy a set of big dividend-paying stocks, you are essentially running a filter for companies in this circumstance. The problem is that decline is a lot harder to manage than growth. The equity value of a declining company can fall much faster than the dividend checks can arrive. This happens often enough that a diversified dividend strategy typically fails.

In a US context, earlyretirementnow.com did a detailed series of analyses showing you are better off in a passive index.

https://earlyretirementnow.com/2019/02/13/yield-illusion-swr-series-part-29/
https://earlyretirementnow.com/2019/03/04/the-yield-illusion-follow-up-swr-series-part-30/
https://earlyretirementnow.com/2019/03/06/yield-delusion-swr-series-part-31/
https://earlyretirementnow.com/2020/10/14/dividends-only-swr-series-part-40/

[Panly]

Most of the people recommending a dividend strategy are using survivorship bias ...

The irony is that those who recommend an S&P500/USA  index fund rely even a lot more on survivorship bias. And home country bias, of course. 


That's  why nobody here ever boasts about their smart choice of other broad based Vanguard index funds, like for instance VWO






   

[Telecaster]

Most of the people recommending a dividend strategy are using survivorship bias ...

The irony is that those who recommend an S&P500/USA  index fund rely even a lot more on survivorship bias. And home country bias, of course. 

That's  why nobody here ever boasts about their smart choice of other broad based Vanguard index funds, like for instance VWO

That might be part of it, but there are some good reasons too.   Keep in mind also there have been lots of discussions about the advantages and disadvantages of owning foreign stocks, so it isn't like the topic never gets discussed.   That said, the groundbreaking work that lead to the 4% rule was done with US stocks and US CPI, in large part because those data were available and those data are the best understood.    And when you boil it down, US companies as a whole do a better job returning money to the shareholders than foreign companies do as a whole.   So that raises a good question about the benefits of foreign investing.   Like maybe there aren't many.   

[clifp]

Most of the people recommending a dividend strategy are using survivorship bias ...

The irony is that those who recommend an S&P500/USA  index fund rely even a lot more on survivorship bias. And home country bias, of course. 

That's  why nobody here ever boasts about their smart choice of other broad based Vanguard index funds, like for instance VWO

That might be part of it, but there are some good reasons too.   Keep in mind also there have been lots of discussions about the advantages and disadvantages of owning foreign stocks, so it isn't like the topic never gets discussed.   That said, the groundbreaking work that lead to the 4% rule was done with US stocks and US CPI, in large part because those data were available and those data are the best understood.    And when you boil it down, US companies as a whole do a better job returning money to the shareholders than foreign companies do as a whole.   So that raises a good question about the benefits of foreign investing.   Like maybe there aren't many.

I've been dutifully rebalancing into foreign stock ETFs for over a decade.  A couple of years ago, I said screw it, I quit. I'm not selling my existing foreign shares (13%) but I'm done trying to get it up to 20 or even 15%.  I'm in charge of managing a non-profits endowment, and I said the same thing to the UBS managers. They wondered about that too.   When I started working in Silicon Valley in the early 1980s, there were a number of large European tech firms, and as well as host of huge Japanese tech firms, like Sony.  Sure the Apples, Intel, Adobes in Silicon Valley as well as Microsoft were hot, but companies like Siemens were much bigger.   But there haven't been any European FAANG stocks in decades, and even some former high flyers like Nokia are dead now.  South Korean, and Taiwan have done well, Japan has faded.  China has plenty of successful tech companies, but the primarily seem to be focused on huge Chinese market.  I think there are structural barriers which makes creating the next Google or Amazon in Europe really hard.

So I think there are good reason for European to own US stocks not so sure if the reverse is true.

[Brit71]

Most of the people recommending a dividend strategy are using survivorship bias ...

The irony is that those who recommend an S&P500/USA  index fund rely even a lot more on survivorship bias. And home country bias, of course. 

That's  why nobody here ever boasts about their smart choice of other broad based Vanguard index funds, like for instance VWO

That might be part of it, but there are some good reasons too.   Keep in mind also there have been lots of discussions about the advantages and disadvantages of owning foreign stocks, so it isn't like the topic never gets discussed.   That said, the groundbreaking work that lead to the 4% rule was done with US stocks and US CPI, in large part because those data were available and those data are the best understood.    And when you boil it down, US companies as a whole do a better job returning money to the shareholders than foreign companies do as a whole.   So that raises a good question about the benefits of foreign investing.   Like maybe there aren't many.

I've been dutifully rebalancing into foreign stock ETFs for over a decade.  A couple of years ago, I said screw it, I quit. I'm not selling my existing foreign shares (13%) but I'm done trying to get it up to 20 or even 15%.  I'm in charge of managing a non-profits endowment, and I said the same thing to the UBS managers. They wondered about that too.   When I started working in Silicon Valley in the early 1980s, there were a number of large European tech firms, and as well as host of huge Japanese tech firms, like Sony.  Sure the Apples, Intel, Adobes in Silicon Valley as well as Microsoft were hot, but companies like Siemens were much bigger.   But there haven't been any European FAANG stocks in decades, and even some former high flyers like Nokia are dead now.  South Korean, and Taiwan have done well, Japan has faded.  China has plenty of successful tech companies, but the primarily seem to be focused on huge Chinese market.  I think there are structural barriers which makes creating the next Google or Amazon in Europe really hard.

So I think there are good reason for European to own US stocks not so sure if the reverse is true.

A lot of the commentary seems to be based on the present continuing for a long time.

The point of diversification - whether an individual portfolio or within index funds - is to shield from risk, and one of the strongest (and surest) risks is that an existing trend will continue for ever.

FAANG shares are probably the strongest trend of the last decade.  Personally I can't see the circumstances where their market dominance and so their constant capital growth, won't continue.  But continuing for the next ten years let alone the fifty odd remaining years of my lifetime is exceedingly unlikely because market trends very rarely last that long.

So the argument for diversifying abroad, and diversifying out of tech stocks, is that the trend will die before you do.

[SeattleCPA]

Well here in the US, divideds are less tax efficient than capital gains.

Aren't qualified dividends taxed like long-term capital gains? E.g., there's a preferential rate (0%, 15% or 20%)?

And then, I guess, aren't nonqualified dividends taxed like short-term capital gains?

[PDXTabs]

Well here in the US, divideds are less tax efficient than capital gains.

Aren't qualified dividends taxed like long-term capital gains? E.g., there's a preferential rate (0%, 15% or 20%)?

And then, I guess, aren't nonqualified dividends taxed like short-term capital gains?

But qualified dividends are like forced long term capital gains then, right? So potentially forcing you into the 20% bracket now when you will be in the 0% bracket later?

Also, not all foreign corporations qualify for the qualified dividends, but they are allowed long term capital gains, right? Then there is the double taxation possibility for foreign dividends but not capital gains.

[ixtap]

Well here in the US, divideds are less tax efficient than capital gains.

Aren't qualified dividends taxed like long-term capital gains? E.g., there's a preferential rate (0%, 15% or 20%)?

And then, I guess, aren't nonqualified dividends taxed like short-term capital gains?

For the last few years, all of our dividends and interest are pushed into the 18% bracket (NIIT). Being able to choose to sell for capital gains means we can wait until we are in the 0-15% bracket. We can add another lever by withdrawing from Roth.

[ATtiny85]

Well here in the US, divideds are less tax efficient than capital gains.

Aren't qualified dividends taxed like long-term capital gains? E.g., there's a preferential rate (0%, 15% or 20%)?

And then, I guess, aren't nonqualified dividends taxed like short-term capital gains?

If you talk capital gains, it’s probably worth also mentioning basis. $1000 in dividends is $1000 subject to taxes. Selling $1000 of a mutual fund is not $1000 subject to taxes unless your basis is zero. Just a reminder…and of course there are fifty other small nuances involved.

[Gomo]

Well here in the US, divideds are less tax efficient than capital gains.

Aren't qualified dividends taxed like long-term capital gains? E.g., there's a preferential rate (0%, 15% or 20%)?

And then, I guess, aren't nonqualified dividends taxed like short-term capital gains?

Correct on both. MFJ for 2022 can make $109,250 in qualified dividends or long term capital gains and pay zero in fed taxes using the standard deduction. Very nice benefit.